Is the Real Estate Boom All Sizzle?

According to news headlines, the housing recovery is real and could drive the economy up in a similar way to how housing drove down the economy a few short years ago. Indeed, the data bear out that the housing recovery is real … for now. Home values were up 20% in some markets in 2012, inventory is low, foreclosures are down, and investors are scrambling to find good deals. Whether you are an investor, a note buyer, or just a family wanting a place to live, the future looks bright. Even a financially conservative mortgage buyer like me believes that the next 12-24 months will shine for real estate.

Can this housing recovery keep going? My own analysis and gut feeling are that we are building up to another real estate bubble. There are three overall reasons for this.

1. Credit has Become Overextended

Bill Gross of PIMCO recently wrote an article called “Credit Supernova” that explained how much new credit is needed to generate one dollar of GDP. In the 1980’s, that ratio was 4 to 1. Since 2006, it has required $20 of new credit to create that same dollar. Gross referred to this as Ponzi Finance, as more credit is required and starts to consume itself. Eventually, interest payments get so large that they cannot be managed and then the collateral damage spreads to other entities.

The U.S. government is the biggest debtor, with no way to pay its future obligations. Since no elected official or bureaucrat wants to be the one associated with significant change in government programs and expenses, they continue to extend and pretend, while the mass media gives them a free pass to say that all is well.

2. Government and Wall Street Too Involved

An article in Zero Hedge phrased it well by stating that actions by the Federal Reserve and the U.S. government have prevented housing from having an organic recovery. Low interest rates forced upon us by the Fed allow the government to pay less interest on its debt and encourage citizens to invest in riskier assets to chase yield. ZH also opined that “high levels of speculative activity could be nurturing a false confidence.” I would have used a stronger pair of words than “could be.”

The government is involved with nearly every mortgage in the country in some fashion. Fannie and Freddie already cost the taxpayers billions of dollars and the Federal Housing Administration (FHA) has so many risky loans and such a high default rate that it is setting itself up for an implosion. If we look back over history, it is clear that government manipulated economies and markets have a poor track record.

At the same time, hedge funds and private equity firms like Blackstone Group and Paulson and Co. continue to spend billions to buy up land and foreclosed houses that they will rent out and eventually sell. At the first sign of a housing decline, companies like these would be quick to the exit door to minimize their losses.

3. Weak Household Wealth

One reason that there are so many all-cash buyers, as well as those at the opposite end seeking an FHA loan so that they can just put down 3.5%, is that the average household has suffered declining wealth over the past few years. States as diverse as California, Alabama, and Alaska have seen a near doubling of food stamp usage over the last five years. A report by the Fiscal Times reported that half of U.S. households (132 million people) are not financially capable of handling a weather emergency or finance long-term needs such as college tuition or health care. Additionally, the report states that “these people wouldn’t last three months if their income was suddenly depleted.” Clearly, this is not just the working poor but also includes a sizable segment of the middle class.

Overall, the housing market is not supported by a strong foundation and has way too much government interference. My personal prediction is that low inventory and low interest rates will carry the housing market for another couple of years, but then all bets are off. Until true unemployment drops significantly and the government gets less heavily involved, we cannot have a natural and long lasting increase in home values.

Free eBook from BiggerPockets!

Get The Ultimate Beginnner's Guide to Real
Estate Investing for FREE - read by more than 100,000 people -
AND get exclusive real estate investing tips, tricks, and techniques
delievered straight to your inbox twice weekly!

18 Comments

Thank you for the realistic view of the real estate market. I consistently am posting articles about how strong the market has become in the last 12 months, but I know that there is nothing to sustain it. I think we should prepare for a downturn, like you said, in the next 12-24 months.

Great article Alan, here in Phoenix there are some prominent wealth managers and economists trying to bring attention to the same details you notice, unfortunately bludgeoned by “Phoenix market is up 30%!!!!!!!!” headlines from local and national media sources.

The thing about it is, it doesn’t “have” to be scary. Cash flow is cash flow despite some of the rampant metrics we’re seeing here.

Look, a $100,000 house that has a 30 year mortgage at 4% getting $900/month in rent, assuming a 30 day vacancy and it took $5K to do a light update and 20% down. If your PITI payment is app $500/month you’re netting $400/month (assuming no HOA and they pay utilities). With the 20k down and 5k to update let’s say you’re all in at 25K to get this deal done and rented, and before tax cash flow is 400/month, that’s a 17.6% cash on cash return, AND having someone pay down your mortgage. It gets even more interesting if you do a lease to own option in which they put down 3-5K (or more) and treat your house as their own. I don’t think some investors care if the market goes down again, sideways, or jumps up (because they’re not betting on those variables to make investment decisions). At the end of the day they have a cheap mortgage that cash flows, tied to a tangible and depreciative asset. Now, I do understand where Dennis (below) is coming from, but at the end of the day you have to make calculated risks with leveraged debt unless you have millions to simply buy homes outright. If you’re smart about it, use the cheap money, in my opinion. “Don’t fight the fed”.

Phoenix, in my opinion, is still a good place to invest, but you have to cherry pick and be smart about it. Flipping is a great way to make money here while prices are rising and inventory is scarce. Harder for the out of staters, as the people here on the ground are usually keeping these to themselves, knowing the same things.

Hi Jeff I added in 5K upfront to update the property, assumed no HOA, and they paid for their own utilities. Of course if there is larger deferred maintenance down the road (roof, water heater, etc), that takes a chunk of gross rents for the year. But I’m assuming the property isn’t horrendous and we’ve done a good job of vetting for tenants who have a homeowners mindset and keep the property up. There may be tax to the respective city for the rental property but that various in city to city. Does that answer your question? PS love the idea, I can see you saying “I totally rocked out with the Rampant Metrics last night, man.” 😉

Tracy,
Yes, Phoenix is scary with how fast it has come back. I am not an expert on that market, but the fast drop and fast recovery in housing prices suggest a very volatile market that is likely to continue. I would be nervous putting too much money there.

In my little area of paradise the construction of new properties is at a fever pace. This is boom being fueled by cheap credit, and money from retirement accounts which have no yield where they were parked.
This phenomenon is also being witness in the stock market where the purchase of high yielding junk bonds are at a fever pace. We all know that this is going to end badly.

I liken this boom to a game of Musical Chairs, when the music stops there are going to be a lot of folks with no place to sit, these are going to lose everything just like the last artificially created cycle we all experienced.

Until the government gets out of rigging the economy by manipulating interest rates for political and financial gain, we will never see stability in our economy again.

For all of those getting into weak deals, or acquiring properties with questionable technical analysis there will be hell to pay when the market goes south.

Remember the chosen few banks have acquired too big to fail status, don’t think massive inflation is going to allow you to pay these loans back with cheap dollars. I can just about guarantee Washington is not going to allow that to happen. Look to Argentina for guidance during hyper inflation, see what status their banking system was granted.

Don’t get me wrong, not a doom and gloom guy here at all, instead I do as I was taught by my father in times of plenty payoff debt and store away some grain into your barns, just in case. Notice the average American uses boom times to acquire even more debt, and puts aside nothing for the future, they act like the boom will never stop. As we have witnessed this is not a good plan over time.

Dennis,
I’m sometimes labelled as a doom and gloom guy, but I just call it like I see it. The scariest part of this and what makes the market that much more unpredictable is the government response. Their continued interference creates a lot of false optimism.

I share the same moniker, but anyone thinking this present economy has not been completely fabricated by the government money printing policies and artificially low interest rates is being foolish and it is going to end badly for those folks.

The typical buy and hold RE investor does not think about properties in the same way as the present players from Wall Street entering the RE market.
They think only of short term gains, and driving up prices to the range where they bailout and take profits. I believe the Blackstone group is one of these major players in Phoenix that being said massive leverage with no skin in the game is usually how they play it.
We have seen in the past when buyers have little or no skin in the game things usually end badly.

I would suggest a short term strategy is best in volatile areas, I know I would be selling into these rising prices.

I concur with Dennis, a short term strategy is what I use for all my private loans. Whether I make a real estate rehab loan or a vertical construction loan, my borrower and I understand the exit strategy is short term.

Regarding volatile markets, I try and not let F.E.A.R.(false evidence appearing real) rule the day. I teach my private lending clients and tell my borrowers, ‘if you can make money in a deal knowing the current market factors, then move forward’.